CFM CFM Valuation & Performance Measurement 1 — Questions and Answers
Question 1: What does the Sharpe ratio measure in fund performance evaluation?
- Excess return per unit of total risk (standard deviation) (Correct answer)
- Excess return per unit of systematic risk (beta)
- Total return divided by the number of trading days
- Return above the benchmark per unit of tracking error
Correct answer: Excess return per unit of total risk (standard deviation)
The Sharpe ratio divides a portfolio's excess return over the risk-free rate by its standard deviation, measuring return per unit of total risk.
Question 2: What is the information ratio (IR) used to assess?
- Active return relative to benchmark per unit of tracking error (Correct answer)
- Total return divided by total volatility
- Excess return over the risk-free rate per unit of beta
- The consistency of a fund manager's alpha generation
Correct answer: Active return relative to benchmark per unit of tracking error
The IR measures a manager's ability to generate excess returns relative to a benchmark, divided by the variability of those excess returns (tracking error).
Question 3: What does time-weighted rate of return (TWRR) eliminate from performance measurement?
- The distorting effect of investor cash flows on portfolio returns (Correct answer)
- The impact of transaction costs on total return
- Currency fluctuation effects on international holdings
- Market timing decisions made by the portfolio manager
Correct answer: The distorting effect of investor cash flows on portfolio returns
TWRR breaks the measurement period into sub-periods at each cash flow event, preventing external cash flows from distorting the manager's actual investment performance.
Question 4: In the context of CAPM, what does alpha represent?
- The return generated in excess of what CAPM predicts given the portfolio's beta (Correct answer)
- The portfolio's sensitivity to market movements
- The risk-free rate component of total return
- The percentage of returns explained by the benchmark
Correct answer: The return generated in excess of what CAPM predicts given the portfolio's beta
Alpha (Jensen's alpha) is the intercept of the security characteristic line and represents value added by the manager beyond market-driven returns.
Question 5: How does the Sortino ratio differ from the Sharpe ratio?
- The Sortino ratio uses downside deviation instead of total standard deviation (Correct answer)
- The Sortino ratio uses beta instead of standard deviation
- The Sortino ratio measures returns against a benchmark rather than the risk-free rate
- The Sortino ratio penalizes upside volatility more than downside
Correct answer: The Sortino ratio uses downside deviation instead of total standard deviation
The Sortino ratio only penalizes harmful downside volatility, making it more relevant for investors who are unconcerned about upside price variation.
Question 6: What is maximum drawdown as a performance metric?
- The largest peak-to-trough decline in portfolio value over a specified period (Correct answer)
- The maximum single-day loss a fund has experienced
- The annualized standard deviation of monthly returns
- The percentage of months a fund posted negative returns
Correct answer: The largest peak-to-trough decline in portfolio value over a specified period
Maximum drawdown measures the worst cumulative loss from a portfolio peak to a subsequent trough, quantifying downside risk for investors.
CFM CFM Valuation & Performance Measurement 1
What does the Sharpe ratio measure in fund performance evaluation?